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On April 1, Treasury released corrections (85 FR 19082) to the final qualified Opportunity Zone (OZ) regulations (TD 9889). The corrections clarify the following issues:

• Applicability dates
• Timing
• Six-month cure provision
• Alternative valuation method
• Sixty-two-month safe harbor for start-ups
• Contributing assets and tax recharacterizations

Background

The IRS published final regulations (TD 9889) on OZs in January 2020 (see Tax Alert 2020-0056). The final regulations addressed what types of gains may be invested and the timing for such investment, when gains may be excluded from taxable income, how QOFs and QOZBs can invest in OZs, how C corporations can invest in OZs, and new rules for QOF C corporations, among other topics. The final regulations were effective on March 13, 2020.

The IRS had issued proposed regulations on investing in QOFs in October 2018 (see Tax Alert 2018-2119) and followed with a second set of proposed regulations in May 2019 (see Tax Alert 2019-0823) (referred to collectively as Proposed Regulations). In the final regulations, the IRS addressed numerous comments received in response to the proposed regulations while retaining the basic approach.

Applicability dates clarified: Taxpayers can rely on certain sections of the proposed regulations and still rely on the final regulations "consistently"

The corrections update most of the "applicability dates" provisions in the final regulations on taxpayers applying the final regulations in a "consistent manner." Under the updated provisions, taxpayers may generally rely on the final regulations but still rely on most sections of the proposed regulations without violating the requirement to apply the final regulations in a "consistent manner." These updates do not apply to Treas. Reg. Section 1.1400Z2(c)-1 (investments held for at least 10 years), Treas. Reg. Section 1.1502-14Z (application of OZ rules to members of a consolidated group), and Treas. Reg. Section 1.1504-3 (treatment of stock in a QOF C corporation for purposes of consolidation). Taxpayers generally relying on the final regulations but choosing to rely on a section of the proposed regulations, must rely on that section of the proposed regulations in its entirety and consistently until the 2021 tax year, when the final regulations must be applied.

• This correction to the final regulations may provide taxpayers with increased clarity and flexibility during the transition period before the final regulations must be applied.

Timing issues clarified

The corrections addressed the timing for a QOF to file its federal income tax return when using the six-month cure for a failing QOZB. The final regulations previously said that the QOF had to file its tax return "not later than" when the cure is achieved. Under the corrections, Treas. Reg. Section 1.1400Z2(d)-1 now says that the return must be filed "not earlier than" when the cure is achieved.

• This correction provides a more logical timeline for the QOF to file its tax return if it has used the six-month cure.

In addition, the final regulations previously said that the determination of whether a QOZB is a qualifying entity "is made by" the QOF on a semiannual basis. Now the corrections state that the determination "may be made by" the QOF on a semiannual basis.

Six-month cure provision applies to each QOZB

Regarding the six-month cure provision, the final regulations said, "[E]ach QOF is permitted only one correction." The corrections state, "Each QOF is permitted only one correction for a trade or business."

• This correction indicates that a QOF may benefit from the six-month cure once for each QOZB in which it is invested, providing increased flexibility for QOFs in meeting the 90% investment requirement.

Value of QOZB stock and partnership interests clarified as unadjusted cost basis under the alternative valuation method

The final regulations state that "the value of each property owned by an eligible entity that is acquired by purchase for fair market value … is the eligible entity's unadjusted cost basis of the asset under [IRC Section] 1012 or 1013." The corrections provide new language, adding that, "Solely for the purposes of this paragraph … the acquisition by a QOF of qualified opportunity zone stock or a qualified opportunity zone partnership interest is treated as a purchase of such interest by the QOF."

• This correction provides QOFs with clarity that the applicable value for QOZB equity is the unadjusted cost basis. Previously, there was some ambiguity around whether QOFs relying on the "alternative valuation method" set forth in the final regulations would be required to assess QOZB equity at fair market value.

Sixty-two-month working capital safe harbor for start-up businesses

IRC Section 1400Z-2 and the final regulations require businesses to meet several requirements to qualify as a QOZB. Among others, these requirements include the following:

• At least 70% of a QOZB's tangible property must meet the requirements for qualified opportunity zone business property (QOZBP) (tangible property requirement)
• At least 40% of a QOZB's intangible property must be used in the active conduct of the trade or business in OZs (intangible property requirement)
• At least 50% of the QOZB's gross income must derive from the active conduct of the trade or business in OZs (gross income requirement)
• Less than 5% of the average of the aggregate unadjusted bases of a QOZB's property may be attributable to nonqualified financial property (e.g., stock, partnership interests, unreasonable amounts of working capital) (NQFP requirement)

The final regulations included a working capital safe harbor, giving QOZBs 31 months of flexibility in meeting these requirements. Specifically, during the 31 months: (1) tangible property that is expected to qualify as QOZBP after applying the safe harbor qualifies as QOZBP; (2) intangible property that a QOZB purchases or licenses under a written plan and schedule for deployment counts as "used" in the active conduct of the trade or business in an OZ; (3) income derived from working capital counts as "gross income derived from the active conduct of the trade or business" in an OZ; and (4) cash, cash equivalents, and debt instruments with a term of 18 months or less are deemed "reasonable" in amount, so they do not violate the NQFP requirement.

According to their Preamble, the final regulations created a "new 62-month working capital safe harbor for start-up businesses," under which eligible start-up companies could benefit from the working capital safe harbor rules previously described to meet the tangible property, intangible property, gross income, and NQFP requirements for up to 62 months, if certain requirements are satisfied. The regulations' text, however, only extended the 62 months of safe harbor protection to the tangible property requirement and the NQFP requirement. The corrections clarify that the 31 months of safe harbor protection can be extended to 62 months for all four of the requirements previously described.

• These corrections give QOZBs applying the safe harbor to multiple capital infusions greater clarity and flexibility in meeting the previously mentioned QOZB requirements within 62 months.

The corrections also add new language on "working capital and property on which working capital is being expended." Under that addition, a QOZB meeting the requirements for the working capital safe harbor satisfies the requirements for QOZBP while it is within the safe harbor period. The corrections further state that "property," presumably meaning cash, cash equivalents, or debt instruments with a term of 18 months or less, is not QOZBP "for any purpose."

• There are several reasonable interpretations of these new provisions; hopefully, Treasury will provide further clarity on this point. One such interpretation is that cash held but not yet expended is not considered in the numerator or denominator of the 70% tangible property requirement, which would be problematic for those QOZBs that start off with "bad" property but will see that property fall below 30% by the end of the working capital safe harbor.

Contributing assets and tax recharacterization

The corrections add a new hypothetical to an example under Treas. Reg. Section 1.1400Z2(f)-1 (Administrative rules — penalties, anti-abuse, etc.) called "Circular Movement of Consideration." In the original example, gain invested into a QOF was deemed to be ineligible related-party gain when (1) the gain was derived from the sale of property to the QOF's QOZB and non-QOZB subsidiaries, and (2) the investor intended, at the time of those transactions, to invest the proceeds into the QOF. Additionally, the property sold to the QOZB did not constitute QOZBP.

Under the hypothetical added by the corrections, the QOF then contributes the capital from the investor to its QOZB and non-QOZB subsidiaries. The circular movement of consideration is disregarded under the step-transaction doctrine and circular cash-flow principles. The investor is deemed to have contributed its assets to the QOF (rather than selling the assets to the QOFs subsidiaries) in exchange for an interest in the QOF. The QOF is deemed to then contribute the assets to its subsidiaries.

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